THE ROLE OF INDUSTRY COMPETITION IN THE LEVERAGE-PERFORMANCE RELATIONSHIP UNDER OVER-INVESTMENT 22032018

THE ROLE OF INDUSTRY COMPETITION IN THE LEVERAGE-PERFORMANCE RELATIONSHIP UNDER OVER-INVESTMENT CONDITION: EVIDENCE IN VIETNAM Abstract Previous studies suggested that the characterist

Thông tin nhóm tác giả:

NCS, Thạc sĩ Châu Văn Thưởng

Khoa Kế toán - Tài chính – Ngân hàng

Trường Đại học Công nghệ Tp HCM (HUTECH)

Tel: 093.827.0871

Email: cv.thuong@hutech.edu.vn

Lĩnh vực nghiên cứu: Tài chính doanh nghiệp, ngân hàng

Thạc sĩ Trần Lê Khang

School of Economics

Erasmus University Rotterdam

Tel: 096.896.7578

Email: Khang.tl@vnp.edu.vn

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NCS Thạc sĩ Nguyễn Công Thành

Department of Economics & Finance - School of Business & Management RMIT University

Tel: 093.858.0239

Email: S3695752@rmit.edu.vn - thanh.nc22@vnp.edu.vn

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Thông tin nhóm tác giả:

Châu Văn Thưởng Nguyễn Phúc Cảnh Trần Lê Khang

Nguyễn Công Thành

THE ROLE OF INDUSTRY COMPETITION IN THE LEVERAGE-PERFORMANCE RELATIONSHIP UNDER OVER-INVESTMENT CONDITION: EVIDENCE IN

VIETNAM Abstract

Previous studies suggested that the characteristics of an industry may play a significant role in the relationship between financial decisions and firm performance through the degree

of concentration or competition Therefore, this research aims to evaluate such a role in order

to clarify the effect of industry competition on the relationship between financial leverage and firm performance Moreover, over-investment is recently considered to be one of the causes leading to bad performance because it tends to worsen the use of debt in the capital structure

As a consequence, the paper is the first one to examine the difference in the impact of industry competition on the leverage-performance relationship in companies with and without over-investment Collected from the financial statements of listed firms on Vietnam’s stock exchange, the dataset covers a wide range of 21 various industries over a seven-year period The research methodology goes through two steps Firstly, it calculates two alternative variables as the representatives of competition and over-investment through different sub-equations Secondly, it adds them to the main regression model to estimate the results with the help of System-GMM technique together with two instrumental variables namely tangibility and non-debt tax shield to deal with the endogenous problem The findings show that capital structure is positively related to firm performance and that the relationship might become stronger at the high level of industry competition Nevertheless, the research indicates that the positive interaction between financial leverage and industry competition gets weaker in case firms carry out over-investment in their projects Thus, these research’s findings are of great importance thanks to their contribution to the existing empirical review and their policy recommendations for not only managers but also investors

Keywords: financial leverage, industry competition, over-investment, firm performance,

Vietnam

JEL Classification: G32, L11, L25

1 Introduction

The leverage-performance relationship is the one that attracts much attention and raises many debates in the science community around the world Modigliani and Miller (1958)

suggests that capital structure has no role to play in firm performance under some assumptions

of a perfect capital market Subsequently, an enormous number of empirical studies have been conducted to reaffirm such a relationship in reality, and all the findings have come to the consensus that capital structure is relevant to firm performance through the trade-off effect, limited liability effect, and discipling effect (Brander & Lewis, 1986; Grossman & Hart, 1983;

Jensen, 1986; Jensen & Meckling, 1976; Khan, 2012; Margaritis & Psillaki, 2010; San & Heng,

2011) However, whether its effect is positive or negative remains debatable and requires a clear question In terms of the positive impact of financial leverage on firm performance, the trade-off between the costs and benefits of debt and equity (Jensen & Meckling, 1976), the limited liability (Brander & Lewis, 1986), and the discipling effect (Grossman & Hart, 1983;

Jensen, 1986) are supposed to be typical theories Whereas, as for the negative effect of financial leverage on firm performance, underinvestment associated with debt (Myers, 1977) and the reactions of stakeholders to financial leverage (Maksimovic & Titman, 1991; Titman,

1984) are considered as the main research domain Furthermore, the predation theory suggests that in industries with the high level of competition, companies that use high financial leverage are more likely to be swallowed by the others operating in the same area (Bolton & Scharfstein,

1990; Chavalier & Scharfstein, 1996; Dasgupta & Titman, 1998)

The condition of industry competition should be taken into consideration when analyzing the impact of financial leverage on firm performance In practice, empirical studies related to the role of industry competition in the relationship between financial leverage and firm performance have given much evidence, especially in the US and some developing countries (Campello, 2003, 2006; Chevalier, 1995a, 1995b; Kovenock & Phillips, 1997; Opler & Titman,

1994) Vietnam has just been added to the list of emerging countries recently with its high economic growth within the two decades, trade openness, the inflow of investment to the economy Furthermore, until now most Vietnamese companies are still dependent on the banking system for their financing sources Therefore, capital structure is vitally important to firm performance in Vietnam (Fu-Min, Wang, Lee, & La, 2014; Gueorguiev & Malesky, 2012;

Tran, Nonneman, & Jorissen, 2015) However, the openness and privatization in various fields

of the economy accidentally increase the pressure of competition among companies within a certain industry (Quy, Khuong, & WilliamSwierczek, 2014; Tran et al., 2015) In short, there

is a need to identify the moderation of industry competition on the relationship between financial leverage and firm performance in Vietnam

Besides the market competition, overinvestment is considered to be another problem that worsens the impact of financial leverage on firm performance According to Agency Theory, the discrepancies in interests between managers and shareholders costs a firm a huge amount

of expenditures to solve the conflicts from both two sides (Gaver & Gaver, 1993; Jensen, 1986;

Jensen & Meckling, 1976) Exposed to the excess in free cash flow, managers are willing to harness firm resources to achieve personal gains One way they often choose is to enlarge sources under their control by carrying out as many investment projects as possible or even worse investing in projects with negative net present value In this situation, it is apparent that overinvestment is a signal of a serious agency problem, making firm operations inefficient Debt is considered as a useful tool in helping reduce the discretionary funds available to managers, putting them under the pressure of fulfilling their financial obligations, and drawing other stakeholders in the market to the monitoring process of managers’ behaviors (Easterbrook, 1984) Based on these theoretical and empirical studies, financial leverage, industry competition, and overinvestment seem to be interrelated to one another and together determine firm profitability

The study aims at analyzing the role of industry competition on the leverage-performance relationship and how this relationship changes when a firm is experiencing overinvestment, which raises two questions: (1) Does financial leverage have a constraining effect on how competitive a market is? and (2) Does overinvestment play a role in adjusting the relationship

on a negative way? In answering these two questions, the study hopes to contribute a part to the academic and practical world For one thing, it provides empirical evidence in an emerging market after the 2008 financial crisis and on the role of industry competition and overinvestment For another thing, it helps investors set up a suitable investment portfolio and the government make appropriate policies in order to promote the freedom of the market as well as heighten Vietnam’s industry competition

The original data includes 699 companies listed on Vietnam’s two stock market exchanges namely HOSE and HNX in the period of 2010 – 2016 However, after the data processing and missing removal, the final dataset covers 208 companies in a wide range of 21 industries from Thompson Reuters source Overinvestment is measured by taking the estimated value of residual from the sub-equation model Competition is calculated in two ways through the opposite HHI Index and the absolute value of coefficients of the sub-equation model (BI Index) Using System Generalized Method of Moments (SGMM) to handle the endogenous

problem caused by the dynamic function, the study indicates the positive relationship between financial leverage and firm performance Moreover, the negative effect of two alternative variables for competition will be lessened through the use of debt The result implies a constraining effect of financial leverage over the competition level Nevertheless, when a firm suffers from the problem of overinvestment, or high agency costs, such the constraining effect

of this two-variable interaction tends to be weaker Besides checking the robustness of the estimation by two different proxies of competition, various representatives of firm performance are also taken into consideration Surprisingly, all results remain consistent both in size and in significance level, supporting the consistency and robustness of the regression model

The paper is divided into 5 sections Section 2 presents the empirical reviews together with hypothesis development Research methodology and estimation are explained in Section

4 and 5, respectively The study ends with the conclusion in Section 6

2 Literature review and hypothesis development:

2.1 Financial leverage and firm performance:

The relationship between financial leverage and firm performance has raised much debates among various studies in corporate finance Based on some assumptions of a perfect capital market without taxes, transaction costs, and asymmetric information, Modigliani and Miller (1958) propose Capital Structure Irrelevance Theory, supporting the idea that capital structure is irrelevant to how effective a firm operates On the other hand, rarely does the capital market have no imperfections When relaxing the assumption of a market without taxes,

Modigliani and Miller (1963) demonstrate the beneficial effects of debt through debt tax shields, that is, the use of financial leverage can help firms obtain the benefits of tax deduction

As comforting the assumption of a market without asymmetric information, Jensen and Meckling (1976) introduce Agency Theory showing the conflicts of interests among managers, shareholders, and creditors Due to the problem of asymmetric information, managers are often more informed of business activities than shareholders are If the free cash flow within a company is abundant, managers are inclined to act in favor of their benefits through seeking higher perquisites and larger control over the company The alignment of the interests between managers and shareholders require a certain amount of agency costs In this case, financial leverage can aid companies with agency problems in reducing these costs when it not only lowers the excessive free cash flow but also exposes firms to different monitoring partners on the capital market with various disciplines and covenants (Grossman & Hart, 1983; Harris & Raviv, 1990; Jensen, 1986) As a result, the research proposes the first hypothesis for the relationship between financial leverage and firm performance

Hypothesis 1: financial leverage is positively related to firm performance

2.2 Financial leverage, industry competition, and overinvestment:

Financial leverage is demonstrated to be associated with the competition level among companies operating in different industries With the limited liability, a leveraged firm’s aggression in competition will allow it to lessen agency problems accompanied by the use of debt in the capital structure (Brander & Lewis, 1986) Such an aggressive behavior is controlled not only by the level of competition but also by the characteristics of the products in the industry (Wanzenried, 2003) Moreover, in a market following the assumptions of Cournot, it is the limited liability that makes firm profitability substantially decrease

Predation theories suggest that firms with high financial leverage are more likely to be disadvantageous in terms of competitiveness compared to those with low debt in their capital structure Fudenberg and Tirole (1986) show that the predation theories are even more obvious

in markets with a high level of concentration Long-existing companies in the industry are inclined to predate newcomers The predation process implies the possibility of lower profitability and more gloomy prospects of these entrant companies If they choose to be financially constrained by borrowing more loans, the use of debt causes themselves to be vulnerable to the risk of predation from other rivals in the market Supporting this idea, Bolton and Scharfstein (1990) explains rival predation through debt covenants employed to reach the alignment between managers and debtholders The restrictions of these debt contracts will push firms to the verge of liquidation and eventually leave the market if they cannot satisfy their obligations Conversely, in a perfectly competitive market where every company only contributes a small part to the whole market’s production, the rivalry predation tends to be negligible (Chevalier, 1995a) suggests that when incumbent companies in some industry employ high financial leverage, it facilitates entrant firms to enter and expand their activities

in the market Leverage, as a consequence, makes the product market more competitive In his extensive analysis, Chevalier (1995b) proves that in a market with both highly and lowly leveraged companies, the former is forced to charge higher prices than the later conditional on high concentration level, making these firms sensitive to the likelihood of predation by their rivals with lower financial leverage

Chavalier and Scharfstein (1996) explain the leverage-competition in another respect using the switching cost models They argue that during a certain recession when most firms’ competitiveness turns out to be less competitive, firms with financial leverage are considered

to be much inferior because they have to charge higher prices than their counterparts, less leveraged firms Thus, a firm’s disadvantage will move in the reverse direction with the product

market’s competitiveness Previously, (Opler & Titman, 1994) support this view by demonstrating that the concentration in the market resulted from industry downturns motivates less leveraged firms to deprive market shares from highly leveraged ones In addition, economic downturns are proven to be highly correlated with less competitive markets Therefore, during

a recession, financial leverage is negatively related to firm performance (Campello, 2003,

2006) Agency problems are attributed to the concentration of the market, and the characteristics of a competitive market can strengthen the discipling effect of financial leverage, reducing agency problems existing within a business (Aghion, Dewatripont, & Rey, 1997;

Grossman & Hart, 1983)

According to Agency Theory, the interests between managers and shareholders are separated (Jensen & Meckling, 1976) Due to asymmetric information between these two sides, managers often take advantage of the managing rights to bring themselves personal gains In doing so, they try their best to expand as much assets under their control as possible to achieve their higher perquisites, secure their positions, and build up their own empire in the company (Brealey, Myers, & Allen, 2008; Hail, Tahoun, & Wang, 2014; Myers, 1984) This leads them

to carry out much investment or even invest in unprofitable projects, exacerbating the problem

of overinvestment Hence, overinvestment is supposed to raise agency problems to the high level and force firms to incur more agency costs (Fu, 2010; Liu & Bredin, 2010; Titman, Wei,

& Xie, 2004; Yang, 2005) Such an effect means that the leverage-competition conditional on overinvestment tends to worsen firm effectiveness The research, in the end, comes to the second and third hypothesis

Hypothesis 2: financial leverage constrains the negative effect of industry competition on

firm performance Hypothesis 3: under the condition of overinvestment, the moderating role of financial

leverage over industry competition seems to be weaker

3 Data and methodology

3.1 Research methodology:

To test these three hypotheses, the study applies the following empirical model

𝐹𝑖𝑟𝑚𝑃𝑒𝑟𝑓𝑜𝑟𝑚𝑎𝑛𝑐𝑒it = α + β1𝐹𝑖𝑟𝑚𝑃𝑒𝑟𝑓𝑜𝑟𝑚𝑎𝑛𝑐𝑒it−1+ β2LEVit+ β3COMjt+

β4LEVitx COMjt+ β5LEVitx COMjt x Over − Investmentit+ ψ′xit+ εit (1)

where ROAit is the return on assets of firm i at time t; α is the constant; LEVit is the ratio of total debt over total assets of firm i at time t; COMjt is the proxy for the level of competition in industry j at time t, namely Herfindahl–Hirschman Index (HHI) and Boone Index (BI);

Over − Investmentit is estimated by the error-term extracted from equation (4); xit is a set of control variables described in the variable definition; εit is the error-term

The representative for firm performance is return on assets (ROA) and return on equity, which are the earning before interests and tax (EBIT), earning before tax (EBT), earning after tax (EAT) divided by total assets and equity respectively Although these variables are thought

to be affected by different accounting standards because its calculation is based on a firm’s accounting books, compared to Tobin’s Q, such a variable is considered to be a better representative for the research Demsetz and Lehn (1985) suppose that ROA and ROE reflect the present situation, while Tobin’s Q shows a firm’s future development Demsetz and Villalonga (2001) emphasize that Tobin’s Q is often affected by tangible assets whose depreciation is different from the real economic depreciation Tobin’s Q depends on the effects

of psychology What’s more, the use of ROA and ROE help mitigate the differences in firm size among companies in various industries Financial leverage is measured by the ratio of total debt over total assets

The research adds some control variables related to firm performance to the regression model including sale growth, firm size, and average return on assets Sale growth (SGRO), the representative for growth opportunities (King & Santor, 2008; Maury, 2006), is measured by the differences between sale of firm i at time t and its sale at time 1 divided by sale at time

t-1 Firm size (Size) is the logarithm of total assets According to Ghosh (2008), average return

on assets (MROA) are the moving average of ROA in two consecutive years The instrumental variables used to handle the endogenous problem in the regression model are tangibility (TANG) and non-debt tax shield (NDTS) TANG is the ratio of tangible assets over total assets This variable plays a decisive role in a firm’s access to financing capital (Booth, Aivazian, Demirguc‐Kunt, & Maksimovic, 2001; Campello, 2006), especially in developing countries where the regulations to protect lenders and carry out loan contracts are loosely controlled NDTS is the sum of research and development funds (R&D) and depreciation divided by total assets

To examine the role of industry competition in the relationship between financial leverage and firm performance, the research has to identify the proxies for industry competition

In fact, there are two ways to measure industry competition: structural and non-structural (Lawton, 1999) Structural approach evaluates market concentration using Herfindahl– Hirschman Index (HHI) (Campello, 2006) or the level of concentration within four or five largest companies in a certain industry (CR4 or CR5) (Campello, 2003; Chevalier, 1995a,

1995b; Kovenock & Phillips, 1997; Opler & Titman, 1994) The degree of concentration (high

HHI, CR4, or CR5) often accompanies lower competition and vice versa Meanwhile, non-structural approach measures the level of competition from the market’s behaviors This measurement is appreciated more highly than structural approach because a high level of concentration does not imply lower competition in the market (Guzmán, Gutiérrez, Cortes, & Ramírez, 2012) In fact, the hypothesis on the relationship between market structure and the effectiveness shows that high concentration is simply the results of the market’s effectiveness (Demsetz, 1973) Some companies that are operating effectively can quickly expand their market shares, while those which are ineffective are smaller and smaller in size (Jan Boone, Griffith, & Harrison, 2004) Moreover, high concentration sometimes comes from the fierce competition of various companies in the market, leading to the fact that effective companies force ineffective ones to exit the market (Jan Boone, 2008a) Thus, the level of concentration cannot correctly predict the level of competition in the market To deal with such problems emerged from structural approach, Jan Boone (2000) uses a new index to measure market competition, Boone Index (BI) The index measures the sensitivity of firm profitability to the ineffectiveness of the market Because in a competitive market companies often have to suffer

a big loss when they perform ineffectively, firm profitability will increase with how effective

a firm performs, and such an increase will be higher in a competitive market (Jan Boone, 2008b)

Hence, BI is the proxy that is preferred in studies on industry competition and firm performance (Jan Boone, van Ours, & van der Wiel, 2013) However, to raise the reliability, the research will in turn employ these two alternatives to find out their impact on the relationship between financial leverage and firm performance According to Beiner, Schmid, and Wanzenried (2011), HHI is measured as the total market shares of each firm in a certain industry

HHIjt = ∑ ( Salesijt

∑Nji=1Salesijt)

2 Nj

i=1

(𝟐)

In the formula, HHIjt is HHI of industry j at time t; Salesijt indicates the sales of firm i in industry j at time t The higher HHI is the higher market concentration becomes (lower market competition)

BI is considered to be the index that helps directly evaluate the level of competition in the market The index is based on the hypothesis of competition and effectiveness with the assumption that in a competitive market, if a firm does not operate effectively, it will incur losses (Jan Boone, 2008b; J Boone, Griffith, & Harrison, 2005; Jan Boone, Van Ours, & Wiel,